Proposed rules would shore up auditing of estimates

The Public Company Accounting Oversight Board is proposing two new standards for auditors that focus on the audit of accounting estimates, one on fair-value measurements and the other on the auditor’s reliance on the work of specialists. Both proposals have been in development for a number of years, even as the board’s inspectors have already been giving auditors grief on those areas through its inspection process and staff members have issued guidance to streamline practice.

“It’s a little bit of the standards catching up to what best practices are,” says Travis Harms, senior vice president and head of the financial reporting valuation group at Mercer Capital. “It’s catching up to where at least many of the Big 4 firms already are in their engagements.”

Accounting estimates have taken on a bigger role in the composition of many public companies’ financial statements in recent years as an increasing number of accounting standards require management to arrive at more assumptions and exercise more judgment. The subjectivity associated with such estimates makes them prone to bias, even manipulation or fraud, which auditors are expected to curb with plenty of skepticism and testing.

As the PCAOB has developed its inspection program, the board has picked apart audit work around accounting estimates and fair value to the point where auditors even appealed to the board to beef up the rules and make the requirements more clear. While the PCAOB took its time, the board has finally rolled out two new proposals meant to codify current expectations.

“Most in the profession are supportive of the PCAOB’s efforts and believe change is needed. The new standards provide a single framework for auditing estimates and provide auditors with greater clarity, he says. “These proposals will drive better use of professional judgment, objectivity, and execution in auditing.”

Paul Drogosch, Senior Audit Partner, Deloitte & Touche

The PCAOB’s first new proposal would build on existing requirements for the audit of accounting estimates by giving auditors some new marching orders in a handful of key areas. It would direct auditors to get more skeptical about the potential for management bias, and it would focus auditor attention on estimates with greater risk of material misstatement.

The proposal would extend some current requirements around the audit of fair-value measurements to all accounting estimates. It would also provide more specific requirements to certain aspects of auditing fair values for financial instruments, especially the use of information from pricing sources, which has been a sore spot in audit inspections the past several years.

The second proposal would beef up the rules auditors must follow when they are reviewing the work of specialists, whether employed by the company or the audit firm, that support financial statement assertions. Specialists would include valuation experts, for example, whose valuations become inputs to the financial statements, but it might also include engineers, geologists, even legal experts offering views on various types of liabilities.

Auditors not only review the work of specialists employed by the company, but they often engage specialists of their own to assist with the audit work. The proposal would amend and align requirements around both groups of specialists, addressing issues such as skills, knowledge, supervision, and objectivity.

Auditors are generally expected to welcome both new standards to codify the direction the profession and regulators have been driving for the past several years. “Most in the profession are supportive of the PCAOB’s efforts and believe change is needed,” said Paul Drogosch, senior audit partner at Deloitte & Touche. The new standards provide a single framework for auditing estimates and provide auditors with greater clarity, he says. “These proposals will drive better use of professional judgment, objectivity, and execution in auditing.”

In terms of how the standards will change current audit practices, Drogosch agrees many firms, especially larger firms, have already responded to the PCAOB’s direction through staff guidance and inspections the past several years to adopt many of the practices that would be required under the new standards. “The PCAOB even notes the bigger firms have spent five-plus years making significant changes to processes, policies, and procedures to respond to the significant number of deficiencies we’ve been getting in these areas,” he said.

SUMMARY

Below is an excerpt from the PCAOB proposed rule summary.

The increasing prevalence and significance of accounting estimates, many with subjective assumptions, measurement uncertainty, and complex processes; the growing use of third-party pricing sources; and the results of the PCAOB's outreach indicate that improvements in the standards for auditing accounting estimates may be needed.

Additionally, the number of audit deficiencies identified in the Board's oversight activities has led the PCAOB to consider whether changes to the existing standards could more effectively prompt the appropriate application of professional skepticism and consideration of potential management bias.

The Board is proposing to replace its existing standards on auditing accounting estimates and fair value measurements with a single standard, Proposed AS 2501, Auditing Accounting Estimates, Including Fair Value Measurements, and to amend the risk assessment standards to more specifically address certain aspects of auditing accounting estimates. The proposed standard would also include a special topics appendix that addresses certain matters relevant to auditing the fair value of financial instruments, including the use of information from pricing services.

The proposal builds on the common approaches in the three existing standards and is intended to strengthen PCAOB auditing standards in the following respects:

Add or revise requirements and provide direction to prompt auditors to devote greater attention to addressing potential management bias in accounting estimates, while reinforcing the need for professional skepticism.

Extend certain key requirements in the existing standard on auditing fair value measurements, the newest and most comprehensive of the existing standards on auditing accounting estimates and fair value measurements, to all accounting estimates in significant accounts and disclosures to reflect a more uniform approach to substantive testing.

Further integrate the risk assessment standards to focus auditors on estimates with greater risk of material misstatement.

Make other updates to the requirements for auditing accounting estimates to provide additional clarity and specificity.

Provide specific requirements and direction to address certain aspects unique to auditing fair values of financial instruments, including the use of information from pricing sources (e.g., pricing services and brokers or

Where firms have not already adapted to the PCAOB’s direction through inspections and staff guidance, that suggests companies could see new demands from auditors for documentation and audit evidence to support estimates and to substantiate the work of specialists. “It would likely increase the workload for auditors and for outside specialists,” says Mark Zyla, managing director at valuation firm Acuitas.

Sara Lord, national director of assurance services at audit firm RSM, says if the standards were adopted as written, companies would not notice a significant difference in how auditors audit estimates from a foundational standpoint. The standard directs auditors to audit estimates by one of the three methods they already employ today—testing management’s process for arriving at a given estimate, developing an independent estimate, or reviewing events or transactions after the estimate to see if they are consistent with the assertions.

Depending on how auditors have adapted already to the regulatory direction of the past several years, companies could face more questions from auditors asking for more specificity around estimates, especially with respect to the sensitivity analysis, Lord says.

The guidance on auditor reliance on pricing sources is especially welcome, says Mike Santay, national partner in auditing standards at Grant Thornton. The PCAOB and even the Securities and Exchange Commission have raised concerns both with management and auditors regarding easy acceptance of third-party information from pricing services and broker-dealers without giving enough thought to whether they are reliable.

The standard would give auditors more specific instruction on how to audit information that comes from third-party pricing services, says Santay. “Some seem pretty prescriptive,” he said. “That could create some additional documentation around how management has arrived at terms and conditions.”

Auditors says there may be some back-and-forth with the PCAOB during its comment and deliberation process about a proposed amendment to audit evidence rules that would affect how auditors approach documentation of equity-method investments in other entities. If an auditor is relying on evidence provided by the investee company to support the investment valuation, the language seems to suggest the auditor will need to dig into that entity’s audit work papers. “That would be a huge change from current practice,” says Lord.

Another possible concern for auditors is focused on international standards. The PCAOB’s proposals for public company audit work are generally consistent with current professional standards for private company audits in the United States and for audits in other jurisdictions under the International Auditing and Assurance Standards Board.

The IAASB is in the midst of changing its standards, however, which are meant to address audits for both public and private companies, large and small, in numerous countries around the world. The IAASB proposal would differ from the PCAOB in some key ways, especially in terms of how to work through risk assessments, says Lord. That raises potential concerns about how to navigate different sets of standards when auditing entities that do business in both the United States and abroad.